The debt service coverage ratio formula is the annual gross rental income divided by the debt obligations of the property.
Annual Gross Rental Income/Debt Obligations = Debt Service Coverage Ratio
To find your Gross Rental Income we take your annual rental income based on your lease agreement and the appraiser’s comparable rent schedule (form 1007) and use the lesser of the two. (In some cases, if you can prove a twelve month history of rental income you can qualify off of that rather than the appraiser’s market rent.)
Next, you’ll need to find your annual debt. Your annual debt for loan qualification purposes equals the total annual principal, interest, taxes, insurance and HOA (if applicable) payments. Annual Debt = Total Annual PITI payments
Next, you’ll divide your annual gross rental income by your annual debt for your ratio. DSCR = Annual gross rental income/Annual Debt
Please note that Net Operating Income (NOI), Capitalization Rate (Cap Rate), Cash on cash return (COCR), Return on Investment (ROI) are not considered for mortgage loan qualifying purposes.
Example of Debt Service Coverage Ratio Calculation
A real estate investor might be looking at a property with a gross rental income of $50,000 and an annual debt of $40,000. When you divide $50,000 by $40,000, you get a DSCR of 1.25, which means that the property generates 25% more income than what is necessary to repay the loan. This also means that there is a positive cash flow in the lender’s eye.
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Why Does DSCR Matter?
The DSCR lets the lender know how to determine a borrower’s ability to pay off their DSCR mortgage. Lenders must forecast how much a real estate property can rent for so that they can predict a property’s rental value.
If you have a DSCR of less than 1.0, it means that a property has potential for negative cash flow. DSCR loans can still be made on properties with less than a 1 ratio however they usually are purchase loans with home improvements / upgrades / remodeling to be made to increase the monthly rent or for homes with high equity and potential for higher rents in the future. You also can potentially get the property above a 1.0 ratio with a DSCR interest only loan.